Foreign Exchange Markets, Intervention, and Exchange Rate Regimes

Abstract

While macroeconomic fundamentals determine the exchange rate at long horizons, there are substantial and persistent deviations from these fundamentals. The market microstructure within which they operate, macroeconomic fundamentals, and policies all affect foreign exchange (FX) markets. The chapter describes the institutional features of these markets, with special emphasis on the process of liberalization and deepening in Indian FX markets, in the context of global integration. Since the mechanics of FX trading affect exchange rates, they have implications for the appropriate exchange rate regime. First, bounds on the volatility of the exchange rate can lower noise trading in FX markets, decrease variance, improve fundamentals, and give more monetary policy autonomy. Second, the speculative demand curve is well behaved under strategic interaction between differentially informed speculators and the Central Bank (CB) when there is greater uncertainty about fundamentals as in emerging markets. So, a diffuse target and strategic revelation of selected information can be expected to be effective. Analysis of Indian experience confirms these research results. CB actions, including intervention and signaling, have major effects.

Appendix: Deriving Equilibrium Noise Trader Entry

Equilibrium requires that a constant number of noise traders, n, enter. Noise trader’s benefit from entry rises with ρ and fall with var(S). Entry will occur only as long as this benefit exceeds their cost of entry. Equation (1) defines an implicit, smooth twice-differentiable benefit function:

$$B\left( {\rho ,\text{var} \left( S \right)} \right);\quad B^{\prime}\left[ \rho \right] > 0,\quad B^{\prime}\left( {\text{var} \left( S \right)} \right) < 0$$

(1)

Where a superscript dash indicates a partial derivative. Trader j will enter the market as long as:

$$B\left( {\rho ,\text{var} \left( S \right)} \right) \ge c_{j}$$

(2)

But both ρ and var(S) are functions of n. Equilibrium ρ, equates demand to supply in the domestic currency security market. It is given by Eq. (3), written implicitly as:

$$\rho^{ * } = \rho \left( {\text{var} \left( S \right),n} \right);\quad \rho^{\prime } \left( {\text{var} \left( S \right)} \right) > 0,\quad \rho^{\prime } \left( n \right) < 0$$

(3)

A superscript ^* denotes an equilibrium value. Similarly, the equation for equilibrium var(S) is written implicitly as:

$$\text{var} \left( S \right)^{ * } = \text{var} \left( S \right)\left( n \right);\quad \text{var} \left( S \right)^{{\prime }} \left( n \right) > 0$$

(4)

In equilibrium either all noise traders will enter, or none will enter, or some will enter, so that $n \in \left[ {0,\overline{n} } \right]$. If B() > c _j for all noise traders, all will enter. If B() < c _j, no noise trader will enter. In an equilibrium with interior values, (2) will hold with equality, and $\overline{\rho }^{ * }$ and var(S)^* will take critical values such that the marginal noise trader is just indifferent to entering.

$$B\left( {\rho^{*} ,\text{var} \left( S \right)^{*} } \right) = c_{j}$$

(5)

At $\rho < \rho^{ * }$ or var(S) > var(S)*, benefits to entry are lower than at equilibrium so n will shrink. Since both ρ and var(S) depend on n, a function G(n) can be defined, that determines entry: $G\left( {\rho \left( {\text{var} \left( S \right),n} \right),\text{var} \left( S \right)\left( n \right)} \right)$. If n ≠ G(n) it cannot be an equilibrium. Hence equilibrium entry is:

$$n^{ * } = G\left( {\uprho\left( {\text{var} \left( S \right),n^{ * } } \right),\text{var} \left( S \right)\left( {n^{ * } } \right)} \right)$$

(6)

If B() > c _j then n < n*, noise trader entry will occur and n will rise. Since ρ falls with n but rises with var(S), and var(S) rises with n, multiple equilibria are possible. $G^{\prime}\left( \rho \right) > 0$ and $G^{\prime}\left( {\text{var} \left( S \right)} \right) < 0$, therefore although G(n) can be high since var(S) is low it falls with n at low n as ρ also falls and decreases G(n). The risk sharing function dominates. But at high n, the positive effect of n on var(S) and therefore on ρ will dominate—ρ will rise as risk rises. Hence G(n) will also rise with n at high n. Therefore equilibria are possible both at low and at high n. Either a few or a large number of noise traders will enter the FX market. But, in each equilibrium n takes a fixed value, given by the function G(n). Noise traders create risk so var(S) rises and ρ falls with their entry (n). But ρ also rises with var(S), since they also share the risk they themselves create.